Archive for July 2nd, 2010

After some initial brouhaha the issue of China allowing its currency to become more market driven, the talks have subsided.

Anyways, Barry Eichengreen and Andrew Rose have written a nice paper looking at the impact.

China’s announcement on Saturday, June 19th that it will abandon its currency peg to the dollar and henceforth manage the renminbi more flexibly against a basket of currencies will have implications for the world economy, but most of all it will have implications for China. Assume for sake of argument that Beijing now allows the renminbi to appreciate.

Some warn that there could be a sharp slowdown in Chinese growth, with adverse effects on the export sector and financial markets. They point to the appreciation of the yen in the 1970s and again in the 1980s, followed first by a sharp slowdown in Japanese growth and then a lost decade. What impact should we expect this to have on the Chinese economy? Others say that these fears are overblown. They note that the renminbi’s appreciation in 2005-8 had little visible impact on Chinese exports and growth. The rebuttal here is that the currency’s appreciation was so limited in duration and magnitude – it rose against the dollar by only 7 per cent a year and even that was halted after 12 quarters – that it is not possible to draw general conclusions from this experience. Moreover, the backdrop to the 2005 episode was special: the world economy was booming, and the Chinese economy itself was in an exceptionally strong position. This episode, it is objected, was sui generis.

So, in this paper the authors look at previous such episodes of currency appreciation and abandoning pegs. What do the results show?

We find little evidence of serious economic and financial damage as a result of exits up. There is no increase in the incidence of banking and financial crises. There is no evidence of significant stock market declines. There is no evidence of a significant deterioration in the current account. There is no evidence of a significant fall in the investment rate. A variety of other economic and financial variables are similarly unaffected.

There is, however, weak evidence a deceleration in economic growth from relatively high levels. The average annual growth rate falls by roughly a percentage point between the five years before and after the policy event. This suggests that the preference of Chinese officials for moving gradually is well founded. But, if they do, they need not worry about a crash.

What causes growth to decline?

So we have something of a paradox. Growth slows by a percentage point around the time of exits up but there is no other visible change to the economy. Should the decline in the growth rate, which misses statistical significance (just marginally) at the 90 per cent confidence level be dismissed as a statistical anomaly? To get a better handle on this question, we look next at the rates of growth of the components of GDP. Export growth slows significantly, from 9.7 per cent per annum in the five years preceding the exit to 6.4 per cent in the five years following (the difference is significant at the 95 per cent confidence level); this is an expected effect of currency appreciation. But import growth slows by almost the same amount. And as we saw above there is no visible change in the current account.

The rates of growth of both investment and government spending fall slightly following exits up, but neither change remotely approaches statistical significance at any reasonable confidence level. The component of GDP that lies behind the slowdown in growth turns out to be household consumption. The rate of growth of household consumption falls from 6.0 to 4.3 per cent per annum between the five years prior to and following exits up. With the country exporting less, households consume fewer imports and domestically-produced goods alike.

One interpretation, again, is that this is a healthy adjustment that avoids overheating. Another interpretation is that, had the authorities been prepared to support spending by increasing government consumption and by adopting measures, such as financial liberalization and the development of a social safety net, to promote the growth of private consumption, any slowdown could have been avoided.

So what are the suggestions for Chinese economy?

What are the implications for Chinese economic policy and performance? The experience of other countries gives little reason to think that an exit up will have seriously adverse consequences for the economy. But it points to the possibility of economic growth slowing at least marginally. If the authorities wish to limit the risk of an excessive slowdown, they can maintain the level of public spending and redouble their efforts to foster the growth of private consumption. If more domestic spending means more spending on, among other things, imported goods, this will represent a Chinese contribution to global rebalancing

Hmmm. Very useful stuff.

The authors say they are not aware of any previous work on such an event. Infact most research looks at abandoning pegged exchange rates but currency depreciates. This has usually been the case in cases of currency crisis. So, the event may not be unique but no studies have been done in the past on this event.

As exchange rate classification etc is difficult as well, it was a task to arrive at a dataset to analyse.

The base rate drama is more or less over. It was so busy in the last 2-3 days with each bank announcing its base rate amidst much fanfare. Banks were asked to announce their base rate and methodology by July 1, 2010.

Krugman points to Iceland crisis. He says, although Iceland is generally considered to have experienced the worst financial crisis in history, its punishment has actually been substantially less than that of other nations.